The Evolving Role of China and India in the Global ... - ResearchGate

P.R. Lane, S.L. SchmuklerTable 1 Composition of foreign assets and liabilities, 2004ChinaIndiaAssets Liabilities Assets LiabilitiesPortfolio equity 0.3 2.9 0.1 9.1FDI 1.9 25.7 1.3 6.4Private debt 13.3 11.9 2.6 17.0Reserves 31.8 18.3Total 47.3 40.5 22.3 32.6Variables are expressed as a percentage of GDP. Source: Authors’ calculations, based on data setconstructed by Lane and Milesi–Ferretti (2007).300%250%200%150%100%50%0%China and IndiaChinaIndia1985198619871988198919901991199219931994199519961998199920002001200220032004300%250%200%150%100%50%0%East Asia and G7G7East Asia1985198619871988198919901991199219931994199519961998199920002001200220032004300%250%200%150%100%50%0%Eastern Europe and Latin AmericaLatin AmericaEastern Europe1985198619871988198919901991199219931994199519961998199920002001200220032004Fig. 2 International financial integration. Sum of foreign assets and liabilities expressed as a ratio to GDP.East Asia is the average of Indonesia, Korea, Malaysia, and Thailand. G7 is the average of Canada,France, Germany, Italy, Japan, UK, and USA. Latin America is the average of Argentina, Brazil, Chile,and Mexico. Eastern Europe is the average of Czech Republic, Hungary, and Poland. The series for theregions are weighted averages where the weights are the countries’ GDPs as a fraction of the region’sGDP. Source: Authors’ calculations drawing on the data set constructed by Lane and Milesi-Ferretti(2007)

The evolving role of China and India in the global financial systemTable 2 Asymmetries in the international balance sheet, 2004ChinaIndiaNet Portfolio Equity −2.6 −9.0Net FDI −23.8 −5.0Net Equity −26.5 −14.1Net Private Debt 1.5 −14.6Reserves 31.8 18.3Net Debt 33.3 3.7Variables are expressed as a percentage of GDP. Net private debt equals non-reserve debt assets minusdebt liabilities. Source: Authors’ calculations, based on dataset constructed by Lane and Milesi–Ferretti(2007).Third, the net foreign asset positions of these countries are more positive than mightbe expected for countries at their level of development.2 The domestic financial sector and international financial integrationThe stylized facts described in the previous section can be explained by developmentsand policies related to China’s and India’s domestic financial sectors. Tounderstand the links between the domestic sector and cross-border asset trade andinternational balance sheets, we summarize very succinctly the trends in three interrelatedaspects of the financial sector: financial liberalization and exchange ratepolicies; the evolution (and state) of the domestic financial sector; and the patterns insavings and investment. We conduct the analysis by turning to the particulardevelopments in the financial sectors of each country.2.1 ChinaChina has adopted a gradualist approach to financial liberalization, including thecapital account, as summarized in Appendix Table 3. During the 1980s and 1990s,the main focus was on promoting inward direct investment flows (FDI). Investmentby foreigners in China’s stock markets has been permitted since 1992 throughmultiple share classes, but access is still restricted. Debt inflows have been especiallyrestricted, as have been private capital outflows. This has allowed the state to controlthe domestic banking sector by, for example, setting ceilings on interest rates.China’s financial liberalization policies have been intrinsically linked to itsexchange rate regime. During 1995–2005, the renminbi (RMB) was de facto peggedto the US dollar. A stable value of the exchange rate has been viewed as a domesticnominal anchor and an instrument to promote trade and FDI. The twin goals ofmaintaining a stable exchange rate and an autonomous monetary policy havecontributed to the ongoing retention of extensive capital controls.These policies have had a large impact on China’s international balance sheet. Onthe liabilities side, the scale of private capital inflows can partly be attributed tospeculative inflows in anticipation of RMB appreciation (Prasad and Wei 2007). 6 To6 Prasad and Wei (2007) highlight that unrecorded capital inflows have been growing in recent years, asforeign investors seek to evade limits on their ability to acquire RMB assets in anticipation of futurecurrency appreciation.

P.R. Lane, S.L. SchmuklerTop Reserve Asset HoldersTop Non-Reserve Asset Holders1 Japan2 China3 Taiwan (China)4 Korea5 India6 Hong Kong (China)7 Russia8 Singapore9 US10 MalaysiaOthers6.0%3.3%21.7%16.0%34.9%1 US2 UK3 Germany4 France5 Japan67 Netherlands8 Switzerland9 Italy10 Ireland23 China49 IndiaOthers0.6%0.1%8.6%18.5%14.3%22.7%0% 10% 20% 30% 40%0% 5% 10% 15% 20% 25%Top Portfolio Equity Liability HoldersTop FDI Liablity Holders1 US23 UK4 Japan5 Ireland6 France7 Switzerland8 Germany9 Netherlands10 Canada22 India24 ChinaOthers0.6%0.6%14.3%20.6%20.1%1 US2 Luxembourg3 France4 UK5 Germany6 Netherlands7 China8 Belgium9 Hong Kong (China)10 Spain36 IndiaOthers0.4%4.1%7.8%22.0%31.7%0% 5% 10% 15% 20% 25%0% 10% 20% 30%Top Debt Liability HoldersShare of World GDP1 US2 UK3 Germany4 France5 Italy6 Japan7 Netherlands8 Spain9 Ireland10 Belgium22 China32 IndiaOthers21.5%17.0%0.6%0.3% 23.7%1 United States2 Japan3 Germany4 United Kingdom5 France6 China7 Italy8 Spain9 Canada10 IndiaOthers1.7%4.7%11.2%28.3%28.5%0% 5% 10% 15% 20% 25%0% 5% 10% 15% 20% 25% 30%Fig. 3 Top foreign asset and liability holders, 2004. The figures show the holdings of foreign assets andliabilities, by type of asset and liability, of the ten largest holders, China, India, and the sum of all the othercountries, as a percentage of total holdings of that type of asset or liability. It also shows the share of worldGDP of the ten largest economies and India. Holdings are expressed as a percentage of the sum of theholdings of all the countries in the data set. Numbers next to holdings show position in world ranking.Source: Authors’ calculations drawing on the data set constructed by Lane and Milesi-Ferretti (2007)avoid currency appreciation, the counterpart of high capital inflows has been therapid accumulation of external reserves and expansion in monetary aggregates. Inturn, the sustainability of reserves accumulation has been facilitated by theregulation of interest rates that has kept the cost of sterilization down (Bai 2006).The gradual liberalization of the domestic financial sector has been accompanied by asharp deepening of the financial development indicators in China during the last

The evolving role of China and India in the global financial system15 years. However, the banking sector remains excessively focused on lending to stateownedenterprises and does not appear to be an adequate provider of credit to privateenterprises and households. An interest rate ceiling also distorts the behavior of banksand limits the attractiveness of banks to domestic and foreign investors (Bai 2006).Despite these deficiencies, the most important supplier of external finance to firms isstill the banking sector. Other important channels are FDI—especially for privatesector enterprises—and the state budget for state-owned enterprises (Allen et al. 2007).With respect to domestic capital markets, the Chinese corporate bond marketremains underdeveloped, while the large overhang of government-owned sharesimplies that tradable shares are only about one-third of total stock marketcapitalization. In addition, equity pricing is perceived as open to manipulation.Furthermore, corporate governance in China remains far from international standards.This contrasts with the focus of the Chinese government on guaranteeingsafety for direct investment. The difference in the protection of foreigners’ propertyrights between direct and portfolio investments has made FDI much more attractivethan portfolio equity for foreign investors wanting to participate in the Chinesemarket. 7The evolution of the domestic financial sector helps explain some elements ofChina’s integration into the international financial system. In particular, the problemsin the banking system (the concentration of its loan book on state-owned enterprises,the significant number of non-performing loans, and solvency concerns) havelimited the willingness of the authorities to allow Chinese banks to raise externalfunds or act as the broker for the acquisition of foreign assets by domestic entities(Setser 2006). 8 In addition, the distorted nature of the Chinese stock market meansthat portfolio equity inflows would have been limited even under a more liberalexternal account regime. Similarly, the domestic bond market is also at a veryprimitive stage of development, while the capacity of domestic entities to undertakeinternational bond issues remains heavily circumscribed.Another channel linking the domestic financial system with the internationalbalance sheet is through domestic savings and investment, with the net difference inturn determining the current account balance. Kuijs (2005, 2006) argues that theextraordinarily high aggregate savings rate in China is primarily driven by corporatesavings. 9 The high level of enterprise saving required to finance high levels ofinvestment has been facilitated by a low-dividend policy. In the extreme case ofmany state-owned enterprises, there are no dividends at all. In some cases, the7 This is not to deny that poor protection of intellectual property rights in China means that much of theinward FDI is confined to labor-intensive sectors that do not rely on proprietary technologies.8 An interesting exception is that domestic residents are permitted to hold dollar deposits in domesticbanks. In 2001, following a further relaxation, a substantial portion of these dollar deposits were employedto invest in B-shares on the Chinese stock market, denominated in foreign currency. See Zhao (2006) andMa and McCauley (2002).9 Others have focused on the role of household savings. But in 2005, household savings have been similarto that of other developing countries. For instance, while the household savings rate in China may havebeen higher than those of OECD economies, it was actually lower than in India.

P.R. Lane, S.L. Schmuklerreluctance to distribute profits reflects uncertainty about ownership structures and theweak state of corporate governance. 10In addition to a low dividend policy, two more factors help explain high enterprisesaving and investment. The first is the high share of the industry sector in GDP,associated with higher saving and investment because of its capital intensity. Thesecond is the rising profits of Chinese enterprises in the last 10 years. These can beexplained in part by the increasing importance of private firms and the increasedefficiency of state-owned enterprises (Kuijs 2006).On the investment side, the reliance on self-financing, and the lack ofaccountability to shareholders plausibly pushes up the investment rate, withcorporate insiders pursuing projects that would not pass the return thresholdsdemanded by commercial sources of external finance. 11 In addition, for state-ownedenterprises, access to directed credit from the banking sector allows these firms tomaintain higher investment rates than would otherwise be possible. Furthermore,restrictions on capital outflows mean that enterprise investment has largely beenrestricted to domestic projects.In sum, the underdevelopment of the domestic financial system may help explainthe high rates of both savings and investment in China. The net impact on the currentaccount is in principle ambiguous, since financial development could reduce bothsavings and investment rates. However, the cross-country empirical evidenceindicates that domestic financial deepening lowers the savings rate and increasesinvestment. 12 Especially in combination with an open capital account, it is plausiblethat higher-quality domestic financial intermediation could place greater downwardpressure on savings than investment. In particular, international capital funneledthrough domestic banks and domestic financial markets to high-return domesticprojects may compensate for a reduction in investment in those inefficiententerprises that are protected by the current financial system. Moreover, a betterfinancial system could stimulate consumption (by providing more credit) and reducethe need for maintaining high savings levels (either for precautionary motives or tofinance future consumption).2.2 IndiaIndia suffered a severe financial crisis in the early 1990s, which subsequently led toa broad series of reforms. The goal was to spur Indian growth by fostering trade,FDI, and portfolio equity flows and, at the same time, avoid debt flows that wereperceived as being potentially destabilizing. In the subsequent years, India hasundergone extensive but selective liberalization, as summarized in Appendix Table 4.But substantial capital controls remain in place.10 However, the recently-established State Asset Supervision and Administration Commission (SASAC) isseeking to assert greater control of state-owned enterprises, including a demand for greater dividendpayments. Naughton (2006) provides an analysis of the political struggle over control and income rights inthe state-owned sector.11 Moreover, the lack of financial intermediation distorts investment patterns, with young or pre-natalfirms starved of finance while mature firms inefficiently deploy excess cash flows.12 See International Monetary Fund (2005).

The evolving role of China and India in the global financial systemThe discouragement of external debt has restricted the ability of domestic entitiesto issue bonds on international markets and the entry of foreign investors to thedomestic bond market. 13 Moreover, there are restrictions on purchases by foreignersin the corporate and government bond markets. Hence, the market for private bondsremains underdeveloped.By contrast, the approach to equity inflows has been much more liberal. Whereasrestrictions on FDI inflows have been progressively relaxed, the distinctivecharacteristic of equity flows into India is not the direct investment, rather therelatively high level of portfolio equity financing. India’s broad domesticinstitutional investor base has facilitated the entry of foreign institutional investors(FIIs) that are permitted to take partial stakes in equity of quoted Indian enterprises.As a consequence of these restrictions on external transactions and other measures todevelop equity markets, the composition of capital inflows has shifted toward higherequity to debt ratios of capital inflows and firms’ financial structures.In terms of capital outflows, the current constraints on asset allocation mean thatofficial reserves are the predominant component of foreign assets. As in China, thede-facto exchange rate/monetary regime seeks to maintain a stable value of the rupeeagainst the dollar, which provides a nominal anchor and is viewed as promotingtrade and investment. The exchange rate regime has been supported by capitalcontrols, which have allowed some degree of monetary autonomy to be combinedwith the exchange rate target.Another channel linking the domestic financial system with the internationalbalance sheet is through domestic savings and investment. India’s current saving rateis similar to that of most other Asian economies; on the investment side, privateinvestment has risen steadily, while public investment has been declining since the1980s. In comparing investment levels in China and India, Mishra (2006) highlightsthat an important difference is that India’s sectoral growth pattern is more orientedtoward services and is thereby less intensive in physical capital, although this mightbe poised to change. 14As is the case in China, it is plausible that further development of the domesticfinancial sector may prompt a decline in household and corporate savings rates, inresponse to greater availability of credit from the financial system. Even morestrongly than in China, further financial development may also stimulate anexpansion in investment, in view of the credit constraints faced especially by smallandmedium-sized enterprises. In addition, financial development that is accompaniedby further capital account liberalization will also stimulate a greater level ofcross-border asset trade, with the acquisition of foreign assets by domestichouseholds and enterprises and the domestic financial system intermediatinginternational capital flows to domestic entities.13 Patnaik and Shah (2006) also highlight that the composition of external debt has shifted in recent years,with private debt and official government external debt in decline but the quasi-sovereign debt ofparastatals increasing. A part of the quasi-sovereign debt is the State Bank of India debt, which isguaranteed by the government. The other part is non-resident Indian deposits in banks, which are notguaranteed, but the State has no track record of allowing non-trivial banks to fail.14 Kochhar et al. (2006) argue that the next phase of Indian development may require a higher level ofphysical investment to absorb low-skilled labor and improve public infrastructure.

P.R. Lane, S.L. Schmukler3 Impact on the global financial systemKeeping in mind the framework set above, this section addresses a series of issuesthat have emerged concerning the impact of China and India on the global financialsystem. We group these issues into three broad questions that have already capturedattention and, where relevant, highlight the differential impact of China and India ondeveloped and developing countries.3.1 How important are China and India as a destination for external capital?The level and composition of China’s and India’s external liabilities are likely tochange, especially as domestic financial reform and external liberalization deepen.As a benchmark, an increasing share of these countries in world GDP and worldfinancial market capitalization should naturally see increasing capital inflows tothese countries. In addition, we may expect to see some rebalancing in thecomposition of external liabilities. For China, reform of the domestic bankingsystem and the development of its equity and bond markets may reduce its heavyreliance on FDI inflows as alternative options become more viable. A reduction inthe relative importance of FDI may also be supported by moves to limit thegenerosity of the current incentives offered to foreign direct investors, which wouldattenuate FDI directly and through its attendant impact on round-tripping activity. 15Finally, the expansion of domestic capital markets and reform of the banking systemwould also allow foreign-owned firms to draw on domestic funding sources.With regard to India, recent moves to further liberalize the FDI regime mayincrease the relative importance of FDI inflows. However, the ability of India toattract FDI also depends on more widespread institutional reforms that improve theinvestment environment for foreign investors and encourage them to channel FDIinto the country. A major barrier regarding the liberalization of debt inflows could bethat opening up the capital account may threaten the government’s ability to financeits fiscal deficits at a low interest cost. Under these conditions, further liberalizationmay be delayed until the domestic fiscal situation is further reformed.3.2 How important are China and India as international investors?The rapid pace of reserve accumulation can be interpreted, at the economic level, asthe byproduct of a development strategy that seeks to promote export-led growth bysuppressing appreciation of the nominal exchange rate. For the rest of the world, thishas represented a beneficial terms-of-trade shock, with the increase in manufacturingexports from China leading to a reduction in relative prices and helping to moderateglobal inflation. For suppliers of inputs to China, the increase in export activity hasgenerated an increase in demand, aiding producers of components in other Asiancountries and commodity producers around the world.15 While current policy is strongly pro-FDI, one reason to believe that FDI incentives could be scaled backis provided by the increasing political concerns about excessive FDI inflows. At one level, this relates tothe demands of farmers whose land has been appropriated to provide industrial sites for direct investorsand others (mainly local real estate developers). At another level, domestic firms that compete with foreigndirect investors complain about the favorable treatment accorded to external investors.

The evolving role of China and India in the global financial systemOn the financial front, the high level of reserves acts as a subsidy that lowers thecost of external finance for the issuers of reserve assets—primarily, the US. In turn,this helps to keep interest rates lower than otherwise in these economies. Regardingthe impact on other developing countries, the low global interest rates associatedwith high reserve holdings have also translated into a compression of spreads onemerging market debt, with the “search for yield” raising the attractiveness ofemerging market destinations to international investors (International MonetaryFund 2006a, b).There are several reasons to believe that the pace of reserve accumulation willstart to decelerate. First, the accumulation of reserves comes at a significantopportunity cost in terms of alternative uses for these funds. 16 Since these countriescomfortably exceed the reserve levels that are required to cover imports and debtobligations, the opportunity cost may be high relative to the insurance gains frombuilding up reserves as a precaution against financial risks. Second, to the extent thatinflows are not sterilized, the increase in domestic liquidity associated with reserveaccumulation threatens the possibility of an asset and real estate price boom andmisdirected lending in the domestic economy. Third, it is increasingly appreciated inChina the potential benefits to rebalancing output growth toward expandingdomestic consumption, which would raise living standards even faster and avoidthe external protectionist pressures that have been building up in the US and Europe.Fourth, the move to a more flexible exchange rate system might reduce the pressureon the monetary authority to intervene in the foreign exchange market to maintain ade-facto fixed currency peg.If reserve accumulation were to slow down, this would have several ramifications,other things constant. The removal of the interest rate subsidy would raise the cost ofcapital for the primary issuers of reserve assets. In turn, depending on the policyresponse, this may contribute to a reversal in global liquidity conditions, which mayalso adversely affect the supply of capital to emerging market economies. However,the final effects of changes in reserve accumulation on the international financialsystem are difficult to estimate and depend on the other changes that occur alongwith the deceleration in reserve accumulation, the external net positions, and theircontribution to global imbalances. For example, looking only at reserves does nottake into account the amount of capital absorbed by these countries from theinternational financial system and how that affects global returns.To mitigate the opportunity cost of reserve accumulation, countries may alsodecide to redirect the excess reserves toward a more diversified portfolio ofinternational financial assets, which might include the liberalization of controls onoutward investment by other domestic entities. 17 For instance, Genberg et al. (2005)support the creation of an Asian Investment Corporation that would pool some of thereserves held by Asian central banks and manage them on a commercial basis,16 As an illustration, Summers (2006) assumes that these countries could earn a six percent social returnon domestic investments; Rodrik (2006) compares the yield on reserves to the borrowing costs faced bythese countries.17 Indeed, some redeployment of reserves has already occurred. For instance, China transferred $60 billionin reserves in 2004–2005 to increase the capital base of several state-owned banks. See also the discussionin European Central Bank (2006).

The evolving role of China and India in the global financial systemdollar. As such, the renminbi might start to play a role of one of the few worldreserve currencies in the international financial system, so long as the capitalcontrols are removed and the financial system consolidates. Similarly, the rupeecould increase in importance as a partial anchor for other South Asian currencies.Finally, we note that part of the cross-border capital flows observed for China andIndia reflect round-tripping activities by which domestic entities seek to takeadvantage of the tax and other advantages offered to foreign investors, in a contextof high capital controls. To the extent that such differential treatment is eliminated inthe future through further financial liberalization, the gross scale of the internationalbalance sheets as currently measured would shrink.3.3 What is the contribution of China and India to global imbalances?The net foreign asset positions of China and India have improved sharply in recentyears and are currently small in global terms. Moreover, the Chinese current accountsurplus has continued to increase, although India has returned to running a smallcurrent account deficit. In this sub-section, we discuss whether these patterns mayturn out to be transitory.Based on a combination of a calibrated theoretical model and non-structuralcross-country regressions, Dollar and Kraay (2006) argue that liberalization of theexternal account and continued progress in economic and institutional reform shouldresult in average current account deficits in China of 2 to 5% of GDP over the next20 years, with the net foreign liability position possibly reaching 40% of GDP by2025. 20 Indeed, any general neoclassical approach would predict that China shouldbe a net liability nation, since productivity growth and institutional progress in acapital-poor country offering high rates of return should at the same time boostinvestment and reduce savings. While no similar study exists for India, similarreasoning applies—greater capital account openness and continued reform shouldmean that India might run persistently higher current account deficits during itsconvergence process.If the neoclassical predictions about the impact of institutional reform and capitalaccount liberalization in China and India take hold, a sustained current accountdeficit of the order of 5% of GDP per annum would soon become significant interms of its global impact. Clearly, the global impact of current account deficits ofthis absolute magnitude would represent a major call on global net capital flows. Ofcourse, the feasibility of deficits of this magnitude requires that there are countries inthe rest of the world that are willing to take large net creditor positions. If this is notthe case, the desired savings and investment trends will translate into higher worldinterest rates rather than large external imbalances.Although a neoclassical approach predicts that these countries could run muchlarger current account deficits, there is substantial disagreement about thesepredictions. Critics argue that the neoclassical predictions do not take into accountseveral factors that are unique to China and India and explain the recent past and20 The natural evolution is that the scale of current account deficits will taper off and, if these countriesbecome rich relative to the rest of the world, this phase may be followed by a period in which thesecountries become net lenders to the next wave of emerging economies. See also Summers (2006).

P.R. Lane, S.L. Schmuklerdistinctive nature. Importantly, several studies suggest that savings rates are likely toremain high in China and India. For instance, Fehr et al. (2007) interpret China’srecent savings behavior as indicative of a low rate of time preference and suggestthat China will remain a large net saver. Based on household survey data, Chamonand Prasad (2005) make demographic projections and predict higher householdsaving rates over the next couple of decades. Finally, Kuijs (2006) argues thatstructural factors mean that savings and investment rates in China will decline onlymildly in the decades ahead. With respect to India, Mishra (2006) argues that in thefuture the upward trend of Indian saving rates will continue. For instance, India’sworking age population as a percentage of total population is expected to peak in2035, much later than for other Asian economies.While demographic considerations may mean that savings rates are unlikely toplummet, it is plausible that further domestic financial development and capitalaccount liberalization will induce a downward adjustment in the savings rate. Forinstance, Chamon and Prasad (2005) point out that the savings rate (especially foryounger households) could decline if the growing demand for consumer durableswere to be financed through the development of consumer credit. This would bereinforced by the liberalization of controls on capital flows, which would providegreater competition in the domestic financial sector and more opportunities for riskdiversification, leading to more lending and less savings. In addition, there are recentindications that China plans a range of policy initiatives to raise the domestic level ofconsumption. 21 Moreover, in both countries, improvements in social insurancesystems and the provision of public services would reduce over time the selfinsurancemotivation of high savings rates.To project the net position, it is important to also consider the prospects for thelevel of investment. In China and India, a combination of an improvement indomestic financial intermediation and capital account liberalization would raise theattractiveness of these countries as a destination for external capital and enhance theability of domestic private firms to pursue expansion plans. 22 In the Indian case, aprimary driver of larger current account deficits could be a higher rate of publicinvestment, in view of the deficiencies in the current state of its public infrastructure.In terms of net positions, Dooley et al. (2003) argue that it is possible torationalize persistent current account surpluses by appealing to the reduction incountry risk that may be associated with the maintenance of a net creditor position.However, even if such an externality effect is present, it may not survive aliberalization of controls on capital flows, in view of the powerful private incentivesto invest more and save less.In sum, our projection is that, all else equal, a combination of further domesticfinancial development and capital account liberalization will unleash forces thatinduce larger net resources flows into China and India. While this projection seems21 See the media coverage of the March 2006 Party Congress.22 In view of the high level of inefficient investment in China, it is plausible that corporate governancereforms and higher dividend payouts (together with domestic financial deepening and externalliberalization) could lead to a reduction in the absolute level of investment in tandem with a decline inthe level of enterprise savings. With an increase in market-driven investment and a decline in savings, theprediction of an increased current account deficit would still hold.

The evolving role of China and India in the global financial systemquite robust as a qualitative level, we recognize that other forces may operate in theother direction. In particular, a stalling of the reform process in either country wouldreduce the impetus for greater net inflows. Moreover, even if market-oriented reformcontinues, the relative pace of demographic change in China and, at a later date, inIndia will be an important force toward a more positive net external position.However, even in that case, the composition of capital flows will be radicallydifferent than the current pattern, with the net balance the product of much largergross inflows and gross outflows.4 ConclusionsIn this paper, we have studied the impact of China and India on the internationalfinancial system by examining and comparing both countries, analyzing differentaspects of their international financial integration, and linking the patterns in theirinternational balance sheets to policies regarding their domestic financial systems.Given the evolution and probable changes in their domestic financial sectors, thisanalysis is relevant in projecting the future evolution of the international financialsystem.The main current international financial impact of India and particularly China hasbeen in their accumulation of unusually high levels of foreign reserves. Another salientaspect of their integration is the asymmetry in the composition of their gross assets andliabilities. Their assets are low-return foreign reserves, which are liquid and protect themagainst adverse shocks, but they carry a high opportunity cost. Their liabilities are FDI,debt, and portfolio equity, which typically yield higher rates of return. FDI has beenrelatively more important in China, with portfolio investment taking a lead role in India.Despite recent attention and concerns regarding their effects on developing countries,China and India do not seem to have been crowding out investment elsewhere and,despite a recent acceleration in activity, are not yet major accumulators of non-reserveforeign assets. A striking aspect of their integration has been the reduction in their netliability positions, defying neoclassical predictions that they should be running largecurrent account deficits given their level of development. Whether the shift in China’sand India’s net positions is transient or permanent is a central issue in assessing theireffect on the international financial system.The evolution of China’s and India’s domestic financial systems (including theirexchange rate and capital account liberalization policies) is essential to understandtheir impact on the international financial system. As both China and India are likelyto undergo further financial development and liberalization, these countries are set tohave an ever-increasing role in the international financial system. We project that thenature of their international financial integration is likely to be reshaped. At onelevel, the composition of the international balance sheet will become lessasymmetric—with a greater accumulation of non-reserve foreign assets and a morebalanced distribution of foreign liabilities between FDI, portfolio equity, and debt.This rebalancing should be good news for developing countries that may receive agreater share of the outward investment flows from China and India. At anotherlevel, there is a strong (but not undisputed) prospect that these countries mightexperience a sustained period of substantial current account deficits. In view of their

P.R. Lane, S.L. Schmuklerincreasing share in global output, the prospective current account deficits of Chinaand India may be a central element in the next phase of the “global imbalances”debate. If this scenario plays out, other potential borrowers will receive smaller netcapital flows and/or face a higher cost of capital.The future developments are, as always, difficult to predict and will depend onother factors (like distinct demographic trajectories and economic reforms), domesticpolicy options, and the international environment. Key aspects to monitor whenanalyzing the possible paths that China and India may pursue (and their impact onthe international system) include the following elements. First, it is essential to watchwhat approach these countries adopt regarding their exchange rate policy,particularly in light of the sustained appreciation pressure (from the market andthe international political environment). While significant appreciation may beresisted in the short run by further reserve accumulation, this is increasingly costlyand may compromise other policy objectives. Second, a sharp correction in the USdollar vis-à-vis other major currencies may act as an external trigger for a switch togreater exchange rate flexibility in China and India, as the renminbi and the rupeewould become (more) undervalued relative to those major, relevant currencies.Indeed, concerns about such a correction may also prompt these countries to alter thecurrency composition of reserves, affecting interest rates and possibly exchange rates(at least in the short run). A third key component to monitor is how fast thesecountries substitute reserve holdings for other assets abroad. To the extent that theinternational environment keeps being favorable, it is likely that some of theproposals to shift away from traditional reserve holdings start to materialize. Fourth,a fully-fledged liberalization of capital controls remains unlikely in the short tomedium term, in view of the outstanding weaknesses in coping with unrestricteddebt flows. However, it is likely that these countries will continue to liberalize theirfinancial sectors, with implications for the composition of their international balancesheets and net foreign asset positions. The exact form of this liberalization process,its timing, and its pace are still to be determined and will remain a subject ofattention. For all these reasons, we anticipate that the international financialintegration of China and India is set to undergo significant reshaping in the yearsto come.Acknowledgement This paper draws on the longer study contained in Lane and Schmukler (2007). Wethank many colleagues at the IMF and the World Bank for interacting with us at the initial stages of thisproject. For useful comments, we are grateful especially to Bob McCauley and Alan Winters, and also toRichard Cooper, Subir Gokarn, Yasheng Huang, Phil Keefer, Aart Kraay, Louis Kuijs, Jong-Wha Lee,Simon Long, Guonan Ma, and T.N. Srinivasan. We also are grateful to participants at presentations held atthe World Bank China Office (Beijing), the World Bank headquarters (Washington, DC), the conference“China and Emerging Asia: Reorganizing the Global Economy” (Seoul), the Indian Council for Researchon International Economic Relations—World Bank conference “Increased Integration of China and Indiain the Global Financial System” (Delhi), the Center for Pacific Basin Studies’ 2006 Pacific Basinconference (Federal Reserve Bank of San Francisco), the National University of Singapore SCAPE-IPS-World Bank workshop (Singapore), and the 2006 IMF–World Bank Annual Meetings (Singapore) for veryhelpful feedback. Jose Azar, Agustin Benetrix, Francisco Ceballos, Vahagn Galstyan, Niall McInerney,and Maral Shamloo provided excellent research assistance at different stages of the project. We thank theSingapore Institute of Policy Studies, IIIS, the World Bank Irish Trust Fund, and the World Bank ResearchDepartment, East Asia Region, and South Asia Region for financial support. The views expressed in thispaper are entirely those of the authors and do not necessarily represent the opinions of the World Bank.

The evolving role of China and India in the global financial systemAppendixTable 3 Brief chronology of China’s financial liberalization since 1990DateDetails1990 Shanghai Securities Exchange was officially recognizedApril 1990 An amendment to the law on Chinese foreign equity joint ventures, stipulating that theState would not nationalize joint ventures, simplifying the approval procedures fornew foreign investment enterprises, and extending the management rights offoreigners was passedMay 1990 Shanghai was opened to FDI, with tax incentives similar to special economic zones.The State Council issued regulations for the sale and transfer of land use rights incities and towns to encourage foreign investors to plan long-term investment.Shenzhen Stock Exchange was officially recognized1991 Shenzhen Stock Exchange was officially recognizedApril 1991 The tax of 10% on distributed profits remitted abroad by foreign investors in foreignfunded enterprises was eliminated, unifying the tax rates on Chinese foreign jointventures and entirely foreign enterprises. Also, more tax benefits were given topriority industrial sectors1992 The B-share market was launchedMarch 1992 Foreign investment was further liberalized, with the opening of a large number of inlandand border areasJuly 1993 Qingdao Beer was the first Chinese firm to list in the Hong Kong Stock Exchange1997 Financial institutions were allowed to issue bonds in international markets with SAFEapprovalFebruary 1999 A private Chinese firm was listed abroad for the first timeFebruary 2001 Domestic investors were allowed to purchase B shares with existing foreign currencydepositsJune 2001 Domestic investors were allowed to purchase B shares with new foreign currencydepositsSeptember 2001 Restrictions were liberalized on purchases of foreign exchange for advance repaymentsof loans and debtsApril 2002 A new four-tier classification was introduced, defining sectors in which foreigninvestment is encouraged, permitted, restricted, or banned. As a result, sectors thatwere previously closed to foreign investment were openedDecember 2002 Qualified foreign institutional investors were allowed to purchase A shares, subject torestrictionsJanuary 2003 Permission from the SAFE was no longer required for domestic residents to borrowforeign exchange from domestic Chinese financial institutionsNovember 2003 In some provinces and regions, the limit on outward direct investment was raised to $3million, from $1 million2004 Insurance companies were allowed to use their own foreign exchange to invest ininternational capital marketsJanuary 2004 The asset requirements for Hong Kong (China) banks to open branches in mainlandChina were lowered to $6 billion, from $20 billion. Other restrictions on Hong Kongbanks were eased tooJune 2004 Domestic foreign-funded banks were not permitted to convert debt contracted abroadinto RMB, and were not allowed to purchase foreign exchange for servicing suchdebts. Capital remitted through FDI could only be converted to RMB upon proof ofdomestic paymentDecember 2004 Foreign heirs were allowed to take inheritance out of the mainland. Emigrants wereallowed to take legally obtained personal assets with them2005 A foreign company was listed in the Shanghai Stock Exchange for the first time.February 2005 Domestic residents were allowed to set up companies abroad to facilitate round-trippinginvestment or overseas financing (issuing bonds and stocks).This made it easier for private firms to access international capital markets and for

P.R. Lane, S.L. SchmuklerTable 3 (continued)DateApril 2006Detailsforeign investment banks/funds to provide financial services to Chinese firmsThe People’s Bank of China announced the qualified domestic institutional investor(QDII) program, under which mainland Chinese financial institutions are allowed toinvest in offshore securities. It stipulated that: (1) qualified banks may assemble thefunds in domestic currency from domestic institutions and individuals and invest thesefunds in fixed income products in international market, (2) qualified security firmsmay assemble funds from institutions and individuals and invest in internationalcapital market including stocks, and (3) insurance companies may invest in foreignfixed income and monetary instrumentsSources: Prasad and Wei (2007) and Zhao (2006)Table 4 Brief chronology of India’s financial liberalization since 1990DateDetailsJuly 1991 The government abolished the industrial licensing system, except in 15 criticalindustries, and reduced the number of industries reserved to the public sector from 17to 6. Government approval for the expansion of large firms was no longer necessary,including foreign firms. Foreign firms were allowed major shareholding in jointventures,and foreign investment up to 51% of equity in 35 priority industries receivedautomatic approval. The new investment policy also spelled more incentives to attractFDI from non-resident Indians, including 100% ownership share in many sectors andfull repatriation of profits1992 The Security and Exchange Board of India (SEBI) Act was passed: the SEBI becameSeptember 1992operational as an independent regulatorForeign institutional investors (FIIs) were given permission to participate in the Indianmarket. One FII could own up to five percent of a firm, and all FIIs combined couldown 24 percent. A minimum of 70 percent investment in equities was required. FIIshad to have at least 50 investors1994 The National Stock Exchange (NSE) began trading bonds in June, and equity inNovember. Differentiating features of the NSE included: equal access to all traders in avast geographical area, a competitive market in security intermediation, electronicmatching of trades on the basis of price-time priority, anonymous trading followed byguaranteed settlement, and a more independent corporate governance structure (not anassociation of brokers)November 1996 “One hundred percent debt FIIs” were permitted. These were allowed to buy corporatebonds, but not government bondsApril 1997 The ceiling upon total ownership by all FIIs of a firm was raised from 24% to 30percent. A shareholder resolution was requiredApril 1998June 1998August 1999February 2000March 2000March 2001FIIs were permitted to invest in government bonds, with a ceiling upon all FIIs puttogether of $1 billionThe ceiling upon ownership by one FII in one firm was raised from five percent to tenpercent. FIIs were permitted to partially hedge currency exposure risk using theforward market. FIIs were permitted to trade equity derivatives in a limited wayThe requirement that FIIs must have at least 50 investors was eased to 20 investors.Foreign firms and individuals were permitted access to the Indian market through FIIsas “subaccounts.” Local fund managers were also permitted to do fund managementfor foreign firms and individuals through subaccounts. The requirement that noinvestor was allowed to have more than 5% of an FII was eased to 10%The ceiling upon total ownership by all FIIs of a firm was raised from 30 to 40%. Ashareholder resolution was requiredThe ceiling upon total ownership by all FIIs of a firm was raised from 40 to 49%. Ashareholder resolution was required

The evolving role of China and India in the global financial systemTable 4 (continued)DateDetailsSeptember 2001 The ceiling upon total ownership by all FIIs of a firm was raised from 49% to “thesectoral cap for the industry.” A shareholder resolution was requiredJanuary 2003 Limitations upon FIIs hedging using the forward currency market were removedDecember 2003 Twin approvals for FIIs at both SEBI and RBI were replaced by single approval at SEBINovember 2004 A new ceiling upon total ownership by all FIIs of corporate bonds was placed at $0.5billionFebruary 2006 The ceiling upon ownership of government bonds by all FIIs was raised to $2 billion,and the ceiling upon ownership of corporate bonds by all FIIs was raised to $1.5billionSource: Patnaik and Shah (2007), Sharma (2000), and Thomas (2005)ReferencesAizenman J, Lee J (2007) International reserves: precautionary versus mercantilist views, theory andevidence. Open Econ Rev (in press)Allen F, Qian J, Qian M (2007) China’s financial system: past, present, and future. In: Brandt Loren,Rawski T (eds) China’s great economic transformation. Cambridge University Press, Cambridge (inpress)Bai C-E (2006) The domestic financial system and capital flows: China. Mimeo, Tsinghua UniversityBlanchard O, Giavazzi F (2006) Rebalancing growth in China: a three handed approach. China WorldEcon 14(4):1–20Caballero R, Farhi E, Gourinchas P-O (2006) An equilibrium model of global imbalances and low interestrates. NBER Working Paper No. 11996Chamon M, Prasad E (2005) Determinants of household saving in China. Mimeo, International MonetaryFund, Washington, DC, USADollar D, Kraay A (2006) Neither a borrower nor a lender: does China’s zero net foreign asset positionmake economic sense? J Monet Econ 53(5):943–971Dooley M, Folkerts-Landau D, Garber P (2003) An essay on the revived bretton woods system. NBERWorking Paper No. 9971Eichengreen B (2007) Global imbalances and the lessons of bretton woods. In: Uzan M (ed) The future ofthe international monetary system. Edward Elgar, Cheltenham (in press)Eichengreen B, Luengnaruemitchai P (2004) Why doesn’t Asia have bigger bond markets? KoreaUniversity/BIS Conference “Asian Bond Market Research,” Seoul, March. Revised version to appearas BIS occasional paperEichengreen B, Park YC (2005) Why has there been less financial integration in asia than in europe? In:Ito T, Park YC, Wang Y (eds) A new financial market structure for East Asia. Edward Elgar,CheltenhamEuropean Central Bank (2006) The accumulation of foreign reserves. Occasional Paper Series No. 43Fehr H, Jokisch S, Kotlikoff L (2007) Will China eat our lunch or take us out to dinner? Simulation thedemographic, fiscal, and economic transition paths of the U.S., EU, Japan, and China. In: Ito T, RoseA (eds) Fiscal policy and management in east Asia. University of Chicago Press, Chicago (in press)Genberg H, McCauley R, Park YC, Persaud A (2005) Official reserves and currency management in Asia:myth, reality and the future. Center for Economic Policy ResearchGoldstein M, Lardy N (2005) China’s role in the revived Bretton Woods system: a case of mistakenidentity. Institute for International Economics Working Paper No. 05-2Goodfriend M, Prasad E (2006) A framework for independent monetary policy in China. IMF WorkingPaper No. 06/111International Monetary Fund (2005) World economic outlook, September 2005International Monetary Fund (2006a) Global financial stability reportInternational Monetary Fund (2006b) World economic outlook database, September 2006Ju J, Wei S-J (2006) A solution to two paradoxes of international capital flows. IMF Working Paper No.06/178

P.R. Lane, S.L. SchmuklerKletzer K (2005) Liberalizing capital flows in India: financial repression, macroeconomic policy andgradual reforms. In: Bery S, Bosworth B, Panagariya A (eds) India policy forum 2004. BrookingsInstitution, Washington, DCKochhar K, Kumar U, Subramanian A, Rajan R, Tokatlidis I (2006) India’s pattern of development: whathappens, what follows. J Monet Econ 53(5):981–1019Kuijs L (2005) Investment and savings in China. World Bank Policy Research Working Paper No. 3633Kuijs L (2006) China in the future: a large net saver or net borrower? Mimeo, World BankLane P (2006) The international balance sheets of China and India. Mimeo, Trinity College DublinLane P, Milesi-Ferretti GM (2007) The external wealth of nations Mark II: revised and extended estimatesof foreign assets and liabilities, 1970–2004. J Int Econ (in press)Lane P, Schmukler S (2007) The international financial integration of China and India. In: Winters A,Yusuf S (eds) Dancing with giants: China, India, and the world economy, world bank and institute ofpolicy studies. A longer version appeared as CEPR Discussion Paper 5852, September 2006, pp 131–132Li D (2006) Large domestic non-intermediated investments and government liabilities: challenges facingChina’s financial sector reform. Mimeo, Tsinghua UniversityLim E, Spence M, Hausmann R (2005) China and the global economy: medium-term issues and options.Center for International Development Working Paper No. 126Ma G, McCauley R (2002) Rising foreign currency liquidity of banks in China. BIS Q Rev September:67–74Mishra D (2006) Financing India’s rapid growth and its implications for the global economy. Mimeo,World BankNaughton B (2006) Top-down control: SASAC and the persistence of state ownership in China. Mimeo,University of California, San DiegoObstfeld M, Rogoff K (2005) Global current account imbalances and exchange rate adjustments.Brookings Pap Econ Act 2005(1):67–146Patnaik I, Shah A (2006) The interplay between capital flows and the domestic Indian financial system.MimeoPatnaik I, Shah A (2007) India’s experience with capital flows: the elusive quest for a sustainable currentaccount deficit. In: Edwards S (ed) Capital controls and capital flows in emerging economies: policies,practices and consequences. University of Chicago Press, Chicago (in press)Prasad E, Rajan R (2005) Controlled capital account liberalization: a proposal. IMF Policy DiscussionPaper No. 05/7Prasad E, Rajan R (2006) A framework for independent monetary policy in China. IMF Working PaperNo. 06/111Prasad E, Wei S-J (2007) The chinese approach to capital inflows: patterns and possible explanations. InEdwards S (ed) Capital controls and capital flows in emerging economies: policies, practices andconsequences. University of Chicago Press, Chicago (in press)Rodrik D (2006) The social cost of foreign exchange reserves. Int Econ J 20(3):253–266Setser B (2006) The Chinese conundrum: external financial strength, domestic financial weakness. CESifoEconomic Studies 52(2):364–395Sharma K (2000) Export growth in India: has FDI played a role? Yale University Economic GrowthCenter Discussion Paper No. 816Summers L (2006) Reflections on global account imbalances and emerging markets reserve accumulation.L.K. Jha Memorial Lecture, Reserve Bank of India, Mumbai, MarchThomas S (2005) How the financial sector in india was reformed. In: Narayanan S, (ed) Documentingreforms: case studies from India. Observer Research Foundation, IndiaWinters LA, Yusuf S (2007a) Introduction: dancing with giants. In: Winters LA, Yusuf S (eds) Dancingwith giants: China, India, and the global economy, World Bank and Institute of Policy Studies, pp 1–34Winters LA, Yusuf S (eds) (2007b) Dancing with giants: China, India, and the global economy, WorldBank and Institute of Policy StudiesZhao M (2006) External liberalization and the evolution of China’s exchange system: an empiricalapproach. Mimeo, World Bank